Minutes for Diamond Lake Investment Club March 14, 2009
"This past week Bernie Madoff moved out of his penthouse and into a gated community." Jay Leno
Concepts discussed at the meeting.
The uptick rule:
When a stock trades, it trades at:
1. A lower price than the last trade
2. A higher price than the last trade
3. The same price as the last trade.
The first two options refer to a change in price. The uptick rule states that in order to sell a stock, the last change in
price must have been up.
The problem that has arisen is that the stock exchanges have changed from trading in increments of 1/4, 1/8 and
1/16 of a dollar as was traditional and have gone to increments of cents. If a person wants to short a stock, they can
buy it at 1 penny more than the last trade and then short as much as they wish.
In order to re-establish the uptick rule, it will be necessary to stipulate something such as the stock price must go
up at least 6 cents (approximately 1/16th point) in the last change-in-price trade.
Whereas this is all well and good, it may not really address the problem. Consider the market makers on the floor of
the New York Stock Exchange and the Chicago Board Options Exchange. In order for these market makers to do
their job, they need to freely buy and sell stock when the prices dictate that they need to correct market
inefficiencies. Such transactions often require shorts and even naked shorts. When I worked for Roger C. many
years ago, I actually shorted a stock and was told later that it was in an account which was set up for market makers
and that they stock which I had shorted had not actually been borrowed from anyone. This happens all of the time
and is legal for registered market makers on the exchanges.
Consider an example of how this might work. As we all have been taught in previous meetings, if one buys a stock
and writes a call against it, the position is equivalent to shorting a put in that same stock. Let us say you buy GE at
$10, write the call for $1 and buy the put for $1. If you do the math, you will find that the long stock minus call plus
the put is a neutral position which will be worth $10 at expiration.
But what if the market maker were to find the put was overrpriced at $2? In order to correct this mis-pricing, he
would sell the put, short the stock and go long the call at $1. He would receive $2 for the put, $10 for the stock and
pay $1 for the call. His position would be neutral meaning that he would take no risk and be assured that the
position would be worth exactly minus $10 at expiration. Since he paid $1 for the call and received $12 for shorting
the stock and the put. Net investment is plus $11 and he will pay only $10 at expiration for a $1 profit.
Look at the chart. Do you see that a long call and short put combine to make a line which is parallel to the stock
price at expiration? Before you trade options, be sure that you can figure such transactions out in your head
quickly. Why? Because other people and their computers can do it all day at lightning speed and if you cannot, you
will "get killed" in the options market.
Now for our point. If you were to tell a market maker who is doing such transactions all day for a living that all of a
sudden he had to wait for an uptick in the stock before shorting it, he would look at you like you are insane. He has
never had the uptick rule apply to him and in fact doesn't even bother to borrow the stock he is shorting. It simply
works that way and always has since the CBOE was founded in 1973 and seats were sold for $10,000 each. It
actually makes sense because the market maker is maintaining a neutral position by hedging everything that he
does. It is a rough and tumble business and not meant for the weak-at-heart.
So the question is can hedge funds naked short or short without an uptick? Well, consider the hedge fund which
owns a seat on the CBOE and therefore is registered as a market maker. Hopefully you are starting to see some of the
complexities which are not discussed on CNBC simply because they are too complicated and reveal too many
"secrets" which appear to be "unfair".
Now consider an ETF which has the job of shorting the financials. An uptick rule cannot possibly apply to them
because they are simply balancing their shares outstanding against short positions in the financial averages.
Now consider something which I have never seen discussed on CNBC or in the press. If you have seen it, let me
know. The consideration is as follows. An amateur in the stock market who is qualified to self-direct his or her own
IRA has to meet certain requirements as to knowledge of the market. In order to go into options trading, the
individual has to declare proficiency and experience in trading options. Covered call writing is one level, but naked
buying of calls or puts requires more experience. To trade commodities, knowledge of commodities is required. The
rules are set up to prevent the amateurs from taking risks beyond their ability or training. Now comes the ETF which
shorts stocks, or goes long commodities such as gold.
Sophisticated investors see the price of gold rising during insecure times much like it did in the 1978 to 1980
period. Old companies are coming out of hybernation and spending millions on marketing their "gold programs".
They know from the past that the public is feeling insecure and many innocent amateurs will be gobbling up their
gold offers. But how should the government protect those amateurs when gold falls off a cliff like it did in the 1980
to 1982 period? Who is going to salve the wounds of individuals who lose gobs of money trading gold in the next few
years? Back then, there were advertisements all over the place telling people to buy gold. Like now, salesmen were
calling people on the phone selling them their doom and gloom stories about run-away inflation. If a person is
restricted from buying calls and yet can buy a triple long or triple short ETF on gold or financials, how is the
government going to protect them?
So it might sound nice to talk about all of those evil hedge funds that short stocks and manipulate markets, but what
about those shysters who convince the unsuspecting public to buy gold or double-long gold just before it drops in
price by half?
Here is another concept discussed at the meeting.
Conventional wisdom tells us all that if we owe $300k on a home valued at $250k, we are not going to be able to
renegotiate our loan for $300k at a lower interest rate. But it appears that such a notion is not so stupid after all.
Consider if you are the bank that holds the non-recourse mortgage and the homeowner is willing to sign a recourse
mortgage for the $300k at a lower interest rate. It is actually beneficial to both parties in the agreement to re-write
such a mortgage and leave it "under water". When the talking heads on CNBC discussed this government proposal
on TV, they didn't understand it and went with the conventional wisdom that NO bank would ever sign a mortgage
which was under water. I will have to admit that I didn't think of the concept until it was mentioned by a
government official. After it soaked into my brain, I began to see how it could actually work.
Another concept is to let the person pay the mortgage on $250k in loans rather than $300k. In this case, the
mortgage rewrite would call for some or all of the money to be returned to the government or bank when the price of
the home finally came back up in the future.
The other concept was that Barney Frank divided the world into to evil banks which made stupid loans on sub-prime
mortgages and good innocent banks which wrote mortgages which were AAA and 20% down but are now victims of
lower prices. It appears that FASB will be changing the mark-to-market rules to accommodate the "good innocent
banks". It is incredible how the politicians seem to talk to the public in fairy book terms.
Don Martin's recommended stocks:
NLY Annaly Agency REIT
NLY-A
CMO Capstead Mortgage
CMO-B
WFC-L
TBT
PALM
From John H.
Last Nights Meeting was lightly attended. We concluded
1) Bill's Pizza makes the best stuffed pizza in town
2) Don likes Wells Fargo preferred L shares (20% dividend)
3) I still like Ford preferred S shares (41% deferred dividend)
4) GE stock is still valued as if GE Financial is worth negative 4 dollars-a-share. GE common stock is up 65% from
it's low in spite of a credit downgrade.
5) No predictions on what the market will do Monday or next week, but financials should continue to perform well as
they debate modifying the Mark-to-Market accounting standard. Ticker FAS is a triple-bull financial ETF. Get ready
to sell on the news.
Here's a five day chart on WFC-PL and F-PS...
"This past week Bernie Madoff moved out of his penthouse and into a gated community." Jay Leno
Concepts discussed at the meeting.
The uptick rule:
When a stock trades, it trades at:
1. A lower price than the last trade
2. A higher price than the last trade
3. The same price as the last trade.
The first two options refer to a change in price. The uptick rule states that in order to sell a stock, the last change in
price must have been up.
The problem that has arisen is that the stock exchanges have changed from trading in increments of 1/4, 1/8 and
1/16 of a dollar as was traditional and have gone to increments of cents. If a person wants to short a stock, they can
buy it at 1 penny more than the last trade and then short as much as they wish.
In order to re-establish the uptick rule, it will be necessary to stipulate something such as the stock price must go
up at least 6 cents (approximately 1/16th point) in the last change-in-price trade.
Whereas this is all well and good, it may not really address the problem. Consider the market makers on the floor of
the New York Stock Exchange and the Chicago Board Options Exchange. In order for these market makers to do
their job, they need to freely buy and sell stock when the prices dictate that they need to correct market
inefficiencies. Such transactions often require shorts and even naked shorts. When I worked for Roger C. many
years ago, I actually shorted a stock and was told later that it was in an account which was set up for market makers
and that they stock which I had shorted had not actually been borrowed from anyone. This happens all of the time
and is legal for registered market makers on the exchanges.
Consider an example of how this might work. As we all have been taught in previous meetings, if one buys a stock
and writes a call against it, the position is equivalent to shorting a put in that same stock. Let us say you buy GE at
$10, write the call for $1 and buy the put for $1. If you do the math, you will find that the long stock minus call plus
the put is a neutral position which will be worth $10 at expiration.
But what if the market maker were to find the put was overrpriced at $2? In order to correct this mis-pricing, he
would sell the put, short the stock and go long the call at $1. He would receive $2 for the put, $10 for the stock and
pay $1 for the call. His position would be neutral meaning that he would take no risk and be assured that the
position would be worth exactly minus $10 at expiration. Since he paid $1 for the call and received $12 for shorting
the stock and the put. Net investment is plus $11 and he will pay only $10 at expiration for a $1 profit.
Look at the chart. Do you see that a long call and short put combine to make a line which is parallel to the stock
price at expiration? Before you trade options, be sure that you can figure such transactions out in your head
quickly. Why? Because other people and their computers can do it all day at lightning speed and if you cannot, you
will "get killed" in the options market.
Now for our point. If you were to tell a market maker who is doing such transactions all day for a living that all of a
sudden he had to wait for an uptick in the stock before shorting it, he would look at you like you are insane. He has
never had the uptick rule apply to him and in fact doesn't even bother to borrow the stock he is shorting. It simply
works that way and always has since the CBOE was founded in 1973 and seats were sold for $10,000 each. It
actually makes sense because the market maker is maintaining a neutral position by hedging everything that he
does. It is a rough and tumble business and not meant for the weak-at-heart.
So the question is can hedge funds naked short or short without an uptick? Well, consider the hedge fund which
owns a seat on the CBOE and therefore is registered as a market maker. Hopefully you are starting to see some of the
complexities which are not discussed on CNBC simply because they are too complicated and reveal too many
"secrets" which appear to be "unfair".
Now consider an ETF which has the job of shorting the financials. An uptick rule cannot possibly apply to them
because they are simply balancing their shares outstanding against short positions in the financial averages.
Now consider something which I have never seen discussed on CNBC or in the press. If you have seen it, let me
know. The consideration is as follows. An amateur in the stock market who is qualified to self-direct his or her own
IRA has to meet certain requirements as to knowledge of the market. In order to go into options trading, the
individual has to declare proficiency and experience in trading options. Covered call writing is one level, but naked
buying of calls or puts requires more experience. To trade commodities, knowledge of commodities is required. The
rules are set up to prevent the amateurs from taking risks beyond their ability or training. Now comes the ETF which
shorts stocks, or goes long commodities such as gold.
Sophisticated investors see the price of gold rising during insecure times much like it did in the 1978 to 1980
period. Old companies are coming out of hybernation and spending millions on marketing their "gold programs".
They know from the past that the public is feeling insecure and many innocent amateurs will be gobbling up their
gold offers. But how should the government protect those amateurs when gold falls off a cliff like it did in the 1980
to 1982 period? Who is going to salve the wounds of individuals who lose gobs of money trading gold in the next few
years? Back then, there were advertisements all over the place telling people to buy gold. Like now, salesmen were
calling people on the phone selling them their doom and gloom stories about run-away inflation. If a person is
restricted from buying calls and yet can buy a triple long or triple short ETF on gold or financials, how is the
government going to protect them?
So it might sound nice to talk about all of those evil hedge funds that short stocks and manipulate markets, but what
about those shysters who convince the unsuspecting public to buy gold or double-long gold just before it drops in
price by half?
Here is another concept discussed at the meeting.
Conventional wisdom tells us all that if we owe $300k on a home valued at $250k, we are not going to be able to
renegotiate our loan for $300k at a lower interest rate. But it appears that such a notion is not so stupid after all.
Consider if you are the bank that holds the non-recourse mortgage and the homeowner is willing to sign a recourse
mortgage for the $300k at a lower interest rate. It is actually beneficial to both parties in the agreement to re-write
such a mortgage and leave it "under water". When the talking heads on CNBC discussed this government proposal
on TV, they didn't understand it and went with the conventional wisdom that NO bank would ever sign a mortgage
which was under water. I will have to admit that I didn't think of the concept until it was mentioned by a
government official. After it soaked into my brain, I began to see how it could actually work.
Another concept is to let the person pay the mortgage on $250k in loans rather than $300k. In this case, the
mortgage rewrite would call for some or all of the money to be returned to the government or bank when the price of
the home finally came back up in the future.
The other concept was that Barney Frank divided the world into to evil banks which made stupid loans on sub-prime
mortgages and good innocent banks which wrote mortgages which were AAA and 20% down but are now victims of
lower prices. It appears that FASB will be changing the mark-to-market rules to accommodate the "good innocent
banks". It is incredible how the politicians seem to talk to the public in fairy book terms.
Don Martin's recommended stocks:
NLY Annaly Agency REIT
NLY-A
CMO Capstead Mortgage
CMO-B
WFC-L
TBT
PALM
From John H.
Last Nights Meeting was lightly attended. We concluded
1) Bill's Pizza makes the best stuffed pizza in town
2) Don likes Wells Fargo preferred L shares (20% dividend)
3) I still like Ford preferred S shares (41% deferred dividend)
4) GE stock is still valued as if GE Financial is worth negative 4 dollars-a-share. GE common stock is up 65% from
it's low in spite of a credit downgrade.
5) No predictions on what the market will do Monday or next week, but financials should continue to perform well as
they debate modifying the Mark-to-Market accounting standard. Ticker FAS is a triple-bull financial ETF. Get ready
to sell on the news.
Here's a five day chart on WFC-PL and F-PS...
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